Retirement planning is not an easy task. To effectively plan for your future, you have to be familiar with all of the different types of retirement savings vehicles, understanding the advantages and drawbacks of each. One of the most popular ways to save for retirement is an investment known as the Roth IRA, which is held by over 26 million American households.
What is a Roth IRA?
An IRA is how Individual Retirement Accounts are commonly referred to as, and the Roth IRA is a particular kind named after the former Senator for Delaware William Roth. He championed the legislation that created this investment program as part of the Taxpayer Relief Act of 1997.
The key characteristic of a Roth IRA is that participants invest money that they’ve earned after paying taxes, but they can ultimately withdraw those funds without paying taxes on those funds. So with a Roth IRA plan, the money you invest is not considered to be tax deductible.
But as time goes by and your investments grow, you’ll still be able to withdraw all of your funds without paying taxes on them. Because of this, a Roth IRA will make the most sense to those who think that their taxes will be higher during retirement than they are now.
How a Roth IRA Works
When you are saving for retirement, you can choose to open a qualifying Roth IRA account. You then invest money into that account, but you aren’t allowed to claim those investments as a tax deduction. But unlike 401(k) plans and some other retirement savings accounts, you can withdraw your investments without having to pay taxes on the funds that you withdraw. The total amount of your Roth IRA withdrawals, including both the original contribution as well as your investment earnings, are received on a tax free basis.
This stands in contrast to the traditional IRAs which did allow you to claim a tax deduction in the year that you made the contribution. And unlike traditional IRAs and 401(k) plans, there are no Required Minimum Distributions (RMDs) to comply with throughout your lifetime. So you can make withdrawals at any time, and in any amount.
Roth IRA Contribution Rules
According to the rules of the program, you can begin contributing to a Roth IRA regardless of your age, and you can continue to contribute so long as you are earning income. In fact, you can contribute to a Roth IRA whether you are employed full time and file a W2, or are a contract worker and receive income under the 1099 tax form. This fact is especially important to the large and growing sector of workers who are part of the so-called gig economy and are not employed full-time by a single employer.
For tax years 2020 and 2021, the maximum contribution that you can make to a Roth IRA is $6,000. However, you can add another $1,000 if you will be 50 year of age or older at the end of the calendar year. This additional amount that you can contribute is often called a catch-up contribution.
All contributions must be made by the tax filing deadline of the following year, which includes extensions such as the ones granted for the 2020 and 2021 tax years in the wake of the COVID-19 pandemic. For example, the IRS has extended the individual filing deadline for 2020 taxes until May 17, 2021. So you can still contribute to your Roth IRA plan until this year’s last filing day instead of the normal tax filing deadline of April 15th. Furthermore, taxpayers that were affected by the 2021 winter storms in Texas have until June 15, 2021 to file their tax returns, make payments and contribute to their 2020 Roth IRA plans.
One aspect of Roth IRA plans that differs from other types of retirement savings accounts are income limits. With a Roth IRA plan, you can only make the maximum contribution if your income falls underneath a certain amount. For single filers, your Modified Adjusted Gross Income (MAGI) must be less than $125,000 in 2021 ($124,000 for 2020) in order to make a full contribution. Those who have incomes between $125,000 and $140,000 for the 2021 tax year ($124,000 to $139,000 for 2020), can make a partial contribution. Contribution is not allowed for those who’s MAGI is $140,000 or more in 2021 ($139,000 in 2020).
For those who are married and filing jointly, or are a qualified widow, the maximum contribution is limited to those who’s MAGI in 2021 is less than $198,000 ($196,000 for the tax year 2020). Those who earn $198,000 up to $208,000 in tax year 2021 will have reduced contribution limits ($196,000 up to $206,000 in 2020). And those who earn $208,000 in 2021 ($206,000 in tax year 2020) are not allowed to contribute.
Also, the rules of the Roth IRA program prevent you from making any contribution if you don’t have earned income. However, your spouse can create and fund a Roth IRA on your behalf if he or she reports earned income. This isn’t a joint account, it’s just an account created and funded by the working spouse in the name of the non-working spouse.
Eligibility and Qualifiers
In order to take advantage of the benefits of a Roth IRA, you first have to determine if you’re eligible for this kind of retirement savings plan. First, you have to have earned some eligible income. This could be regular employment, which includes non-salary income such as sales commissions, bonuses, tips and taxable employee benefits.
Otherwise, you could earn income by owning your own business or a farm. Also, there are other forms of eligible income including untaxed combat pay, military differential pay and alimony payments that are taxed.
However, you can’t invest money into your Roth IRA that’s considered unearned income such as securities and rental property income. Other forms of income that are considered unearned include child support, Social Security retirement benefits, unemployment benefits, wages earned in prison and non-taxable alimony.
Fortunately, there are no age restrictions for contributing to a Roth IRA, so anyone of legal employment age can contribute, and custodial accounts are even available for working teenagers who haven’t turned 18 yet. And you can keep contributing to a Roth IRA up until any age, so long as you’re employed or earning a qualifying income. Note that there had been a rule that prohibited participants from contributing to traditional IRAs after age 70 and ½, but that restriction has since been repealed.
There’s also no restriction against Roth IRA participants contributing to other investment savings programs. So you can contribute to a Roth IRA while participating in your employer’s 401(k) plan at the same time. However, the annual dollar limit for contributions applies collectively to both traditional and Roth IRAs, so the total of all of your annual IRA contributions you can’t exceed the designated limit for your income and filing type.
Advantages and Benefits of Roth IRAs
There are several good reasons why the Roth IRA is a popular way for Americans to save for retirement. The most important is that with a Roth IRA, you’ll receive your retirement savings distributions without having to pay income tax on them. Unlike traditional IRAs and 401(k) plans, you won’t have to pay taxes on your disbursements when you receive them. This is an advantage to lower income workers who may have to pay far less taxes at the start of their career compared to later in life when they might have a higher income and tax rate.
Another advantage of the Roth IRA compared to other retirement savings plans is that there are more ways to make early withdrawals without penalties. For example, you can make a withdrawal for qualified educational expenses, for a birth or adoption, if you become disabled or even for a first time home purchase.
Then there’s the complete lack of required withdrawals based on age. Holders of traditional IRAs and 401(k) plans are subject to Required Minimum Distributions (RMDs) which dictate how much of their retirement savings they will have to withdraw after a certain age. But with a Roth IRA, you’re never required to make a withdrawal and there’s no minimum withdrawal amount that you ever have to comply with.
Then there’s the issue of Roth IRA distributions that could occur posthumously. If you still have assets in your Roth IRA account at the time of your death, then that money can be distributed to your heirs tax free.
Finally, there’s the universal accessibility of the Roth IRA. Unlike employer sponsored plans like a 401(k), anyone who meets the income requirements and limits of a Roth IRA can create an account and contribute to it. You don’t need an employer to sponsor it.
Withdrawals (Qualified and Non-Qualified Distributions)
When it comes time to start making withdrawals from your Roth IRA, you should be aware of the two types of distributions, qualified and non-qualified. Any qualified distributions are made tax fee and have no penalties. To make a qualified withdrawal, you have to comply with the Roth IRA’s so-called five year rule. This means you have to be at least 59 and ½ years old and it has to have been at least five years since you first contributed to any Roth IRA plan. The five year rule even applies if you were to make your first contribution after reaching 59 and ½ years old.
However, the five year rule begins on January 1st of the tax year that you contributed. And because you can make contributions for that tax year up until the tax filing deadline in the next calendar year, you may not need to have your account open for five full calendar years. For example, if you made a contribution on April 15th of 2019 for the 2018 tax year, the five year rule starts on January 1st of 2018 and you can begin making tax and penalty free withdrawals starting on January 1st of 2023, providing that you are at least 55 and ½ years of age.
If you don’t meet the minimum age requirement and the five year rule, or any one of several exceptions, then any withdrawal that you make will be considered to be a non-qualified distribution. Non-qualified distributions are subject to not just income taxes but also a 10% early distribution penalty.
How to Open a Roth IRA
Once you’ve determined that you’re eligible to open a Roth IRA, the process is not that complicated. First, you need to choose where you would like to open your Roth IRA account. To decide which plan to invest in, you’ll want to consider any fees charged to open and maintain the account. You should also take into consideration the quality of the financial institution’s customer service, including its website, mobile app and telephone support. Of course, the plan you decide to go with should offer the kind of investments that you are interested in making such as stocks, bonds or actively managed funds. If you’ll be making your own stock trades, you’ll want to know how much each trade will cost.
After you’ve selected the best Roth IRA account for your needs, you’ll be required to fill out a significant amount of paperwork. But in many cases, you’ll now be able to complete the required forms online. Expect to have to provide detailed information regarding your identity and employment including a photo ID, your Social Security number and the account and routing information number. You will also be asked the name and address of your employer, as well as the name, address, and Social Security number of the plan beneficiary that you designate to inherit any remaining funds at the time of your death.
Now that your account is open, you’ll need to choose your investment strategy. You may create your own investment portfolio or use an off the shelf portfolio designed by the institution that you have your account with. You may also choose to consult a financial advisor that’s employed by the investment company or pick an independent one.
Lastly, you’ll need to set up a contribution schedule. You could choose to schedule monthly or annual contributions, or any other schedule you prefer. You just need to stay below your maximum contribution limit and make any contributions before the filing deadline.
Roth IRA vs. Traditional IRA
One of the best ways to understand Roth IRAs is to compare and contrast them with traditional IRA plans. Here are the key differences:
- Tax status of contributions: Roth IRAs allow you to make post-tax contributions while traditional IRAs may allow pre-tax contributions. This makes traditional IRA contributions tax deductible, while you’ll pay taxes on your Roth IRA contributions.
- Limits on eligibility. Roth IRA participants must have income below a certain level while traditional IRAs are open to all income levels.
- Withdrawals. Traditional IRAs are just subject to the minimum age requirement of 59 and ½ while Roth IRAs withdrawals are subject to both the minimum age requirement of 59 and ½ as well as the five year rule.
- Employer sponsorship. 401(k) plans must be sponsored by and employer, while Roth IRAs don’t have that requirement.
The Roth IRA is a great way to save for retirement, as you can access your savings without having to pay taxes on it when the time comes to withdraw. Roth IRAs also give you more flexibility to withdraw your retirement funds early, without paying penalties. By understanding all of the benefits and drawbacks of these popular plans, you can decide if it makes sense for your needs.